Unexpected Leaders in Election Year 2004

By

Michael Kahn

Updated Oct. 11, 2004 11:59 p.m. ET

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Editor's note: This week Barron's Online will run a Special Report called Election Impact. Getting Technical, Fighting the Tape, Weekday Trader and Electronic Q&A all will try to gauge how the upcoming election will affect investors in the months and years ahead.

WALL STREET HATES the word "unexpected." Unexpected problems, unforeseen events and, of course, earnings surprises are all concepts that usually spook investors and traders alike. Even when they are positive surprises, we are left wondering what we missed.

Some have called the current presidential election a source for a good deal of that dreaded uncertainty affecting stocks.

Indeed, before the primary season got underway in January, pundits were expecting the reelection of President Bush as the Democrats had apparently placed their faith in what looked like an unelectable candidate, Governor Howard Dean. The stock market was coming off a very nice run, as the future was apparently known--at least politically.

Then a supposedly more electable candidate, Senator John Kerry, emerged and stocks peaked for the year, by most measures. The race was on and uncertainty was back (see Fighting the Tape, "Democrats' Dustup Could Shake Up Markets," January 22).

Many studies look at how stocks perform during election years and how they do the following year under Democratic or Republican administrations. Some seasonal studies point out, for example, that years ending with a "5" are good for stocks, and some take it a step further by pointing out that years ending in "5" following an election year have an even better track record.

We'll leave all of that to stock-market-cycle experts to figure out why.

More relevant for us is a study done by the Ned Davis Research Group (www.ndr.com) earlier this year on how individual sectors performed during election years. The results at the time were not surprising and could have been explained by any number of fundamental reasons not limited to the incumbent party doing whatever it can to prop up the economy.

The study concluded that over the past two decades, the top three performing sectors in election years were energy, financial services and health care stocks.

The worst three performers were telecommunications, basic materials and information technology.

If we had followed those precedents and allocated our portfolios accordingly, to date we would have gotten mixed results.

Clearly, energy has been a leader in the real world of 2004, with a year-to-date gain of nearly 30% vs. the Standard & Poor's 500's virtual flat line.

Technology has lagged, with a loss of about 4%, so these two sectors have been true to form.

But that is where the textbook case ends, as expected leaders in the financial sector are also more or less unchanged on the year and normally robust health care has been tumbling.

Telecommunications stocks, expected to lag, have clawed their way to a net gain after a poor start, and basic materials have been on the leader board since midyear, in a dramatic turnaround.

What happened? Again, this is not something we must address on the charts, but the charts usually tip us off to something fundamental that will be happening down the road. Something we do not expect is looming out there, and while it is not necessarily a bad surprise the market as a whole is reacting.

Let's look at the sectors that are behaving unexpectedly, staring with the underachieving health care sector (see Chart 1).

Using the American Stock Exchange's SPDR exchange traded fund (ETF) for this sector, we see that the rising trend line from July 2002, when the rest of the market (except for technology) ended its bear market, has been broken to the downside.

CHART 1

The trend all this year for health care has been down, and the relative performance chart shows the sector actually underperforming the S&P 500 since October 2002, when the Nasdaq Composite index made its final bottom.

For now, this sector appears to be in decline, with support in the 27.50 area.

Meanwhile, after being crushed during the bear market, telecom stocks started the year mirroring the performance of the broad market (see Chart 2).

But then, following history, the sector began to fade, both in absolute and relative terms, until June, when things changed again.

Since then, the telecom group not only has been a leader in relative performance, but it has broken a declining trend line equivalent to the widely followed corresponding trend line on the S&P 500, and has rallied all the way back to its previous peak.

CHART 2

While there is still a long way to go before telecommunications stocks can reclaim their lofty levels of just a few years ago, the group's recent leadership and resiliency in the face of some troubling market conditions (higher oil prices, a slowdown in earnings growth, the Iraq war) suggests something good down the road.

Utilities also weren't supposed to do well in an election year: The group ranked as the fourth worst performer overall, yet it is up some 9% to date in 2004. Not too shabby against a flat, broad market.

So, what are we to conclude from this? Certainly not the most dangerous words on Wall Street: "This time, it is different."

No, there is no new paradigm at work. But are weak health care and technology groups, coupled with a strong basic materials sector, implicitly forecasting the election's results?

We'll all have to wait until after November 2nd to find out.

Also read Getting Technical: The Markets' Mood on Wednesday in Barron's Online.

Getting Technical Mailbag: Send your questions on technical analysis to us at online.editors@barrons.com. We'll cover as many as we can, but please remember that we cannot give investment advice.

Michael Kahn writes the daily "Quick Takes Pro" newsletter and a free version of the same at (www.midnighttrader.com). He is the author of two books on technical analysis, most recently Technical Analysis: Plain and Simple, and was Chief Technical Analyst for BridgeNews. He also is on the Board of Directors of the Market Technicians Association (www.mta.org).

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